Fixed Income Chapter 5

Time preference theory of interest rates

- TIME is the biggest factor affecting interest rates (Rae) - believes interest rates must always be positive (BB) - individuals willing to pay positive interest rate when borrowing (BB) - individuals who are willing to lend at a positive rate in order to require a positive compensation on their investment (BB) - capital is any asset that generates an income flow over time and the value of capital is the present value of that income (Fisher) - interest rate is an index of a community's (market's) preference for a dollar of present income over a dollar of future income (Fisher) "generally interest rate curves should be more positive over time (should rise over time) (should be more productive over time). Interest rates should be positive and the slope of the yield curve should also be positive)

rates on treasury securities (historical)

- between 2 and 7% until '70s crisi - up to 20% under Volcker - afterwards we had economic growth, reduction in inflation rate, decline in abnormally high bond yields, stock market rally - 10 yr Treasurys declined to 1.5 in 2015 and have remained low

Loanable Fund Theory of Interest Rates

- general level of interest rates is determined by the complex interaction of two forces (demand and supply) that set the interest rate level and the level of loans (supply of loans come from people who need capital - gov't, corporations, households, etc.)

3 Major interest rate theories

1) Time preference theory of interest rates 2) Loanable funds theory 3) Liquidity preference theory

4 findings about natural rate of interest

1) evidence of time-variation in natural rate of interest 2) downward trend in natural rate of interest reaching historically low levels 3) substantial co-movement in the natural rate of interest 4) estimates of the natural rates of interest are imprecise

5 arguments against negative interest rates

1) penalizes savers, transfers wealth from savers to debtors 2) negative interest rates encourage individuals to allocate funds to speculative assets (potentially fueling bubbles) 3) bad impact on depository institutions 4) those on pensions (or dependent on interest as source of income) will be worse off 5) defined benefit pension plan sponsors and life insurance companies will have difficulties meeting target returns

4 roles of safe assets in the financial market

1) safe assets used by certain financial entities to satisfy regulatory requirements 2) used as a pricing benchmark 3) used as collateral in financial transactions 4) development of asset pricing theory and derivatives pricing relies on existence of a risk free asset

Liquidity Preference Theory

Individuals will value different portions of the yield curve for different reasons Transaction: short-end of yield curve Precaution: middle Speculation/investing: long-end

ZIRP

Zero Interest Rate Policy

When do banks think of going into negative interest rate territory?

deflationary pressures/ fears with negative interest rates: ppl motivated to spend as depositors are forced to pay banks to keep their money in accounts

Net supply for sovereign safe assets for ______ advanced economies is the key driver of natural interest rates

eleven

Crowding-out effect

gov't borrows so much money and sucks up capital, it makes it harder to private players to borrow

QE

increase its balance sheet by buying outstanding long-term bonds

NAIRU

natural rate of interest is the real short-term interest rate that would prevail if there was stable economic output and a constant inflation rate non-accelerating inflation rate of unemployment

Market expected inflation rate

nominal treasury security yield - TIPS yield = expected inflation ** verify breakevens**

Fisher's Law

the principle that an exchange of money now for money later must imply the same rate of exchange between the commodity now and the commodity later, as implied by the real rate real interest rate = nominal rate - expected inflation